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Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
Demand Management <ul><li>In our first lecture we introduced Aggregate Demand </li></ul><ul><li>We discussed different way...
Demand Management <ul><li>In 2000 George W. Bush wanted to increase consumer spending, so they issued a tax rebate </li></...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
AD, Domestic Product, and National Income <ul><li>Aggregate Demand </li></ul><ul><ul><li>the total amount that all consume...
AD, Domestic Product, and National Income <ul><li>Consumer Expenditure  </li></ul><ul><ul><li>the total amount spent by co...
AD, Domestic Product, and National Income <ul><li>Government Purchases </li></ul><ul><ul><li>the goods and services purcha...
BUT WAIT!!! <ul><li>This is the exact same formula we used to calculate GDP last week! </li></ul><ul><li>How can these two...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
FIGURE  24-1   The Circular Flow of Expenditures and Income 1 3 6 5 4 2 Investors Government Consumers Financial System Sa...
Circular Flow of Spending, Production, and Income <ul><li>Circular flow diagram:  shows the relationship of the different ...
AD, Domestic Product, and National Income <ul><li>National Income </li></ul><ul><li>-the sum of the incomes that all indiv...
FIGURE  24-1   The Circular Flow of Expenditures and Income 1 3 6 5 4 2 Investors Government Consumers Financial System Sa...
National Income vs. Disposable Income <ul><li>Not all national income goes directly to consumers </li></ul><ul><li>Some mo...
AD, Domestic Product, and National Income <ul><li>Disposable Income </li></ul><ul><ul><li>the sum of the incomes of all th...
Some Questions To Think About: <ul><li>Does flow of spending and income grow larger or smaller as we move around the circl...
Some Questions To Think About <ul><li>Do the government’s accounts balance so that net of transfers equals government spen...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
Consumption <ul><li>Consumption is the single largest component of GDP, about 66% over the last decade </li></ul><ul><li>M...
100 5,151 Total Consumption 865 Other 816 Medical Care 205 Transportation 310 Household operation 779 Housing 58 2,974 Ser...
Evolution of Consumption in the 20 th  Century <ul><li>1918-US households spent 41% of income on food and drink </li></ul>...
Evolution of Consumption in the 20 th  Century <ul><li>Housing has risen from 14% to 20% of national income during this pe...
Consumption, Income, and Saving <ul><li>Consumption, Income, and Saving are all linked </li></ul><ul><li>Personal saving  ...
Consumption, Saving, and Income 28,360 +1,640 30,000 27,830 +1,170 29,000 27,240 +760 28,000 26,600 +400 27,000 25,850 +15...
FIGURE  24-2   Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserve...
 
Consumption, Saving, and Income <ul><li>Clearly consumption and DI are related </li></ul><ul><li>When DI rises, consumptio...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
Consumption, Saving, and Income <ul><li>To understand the way consumption affects national output, we need some new tools....
Consumer Spending and Income <ul><li>A scatter diagram with U.S. data shows the close relationship between real disposable...
FIGURE  24-3   Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserve...
Consumer Spending and Income <ul><li>Assume in 1963 you want to calculate how much an increase in disposable income will i...
FIGURE  24-4   Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserve...
Consumer Spending and Income <ul><li>When the data are converted into a consumption function diagram--with income on one a...
Consumer Spending and Income <ul><li>If there were a tax cut of $10 billion, effectively increasing DI by that amount, acc...
The Consumption Function and the MPC <ul><li>Consumption function </li></ul><ul><ul><li>illustrates the relationship betwe...
FIGURE  24-5   A Consumption Function Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 5,200  4,800  ...
TABLE  24-1   Consumption and Income in Hypothetical Economy Copyright © 2003 South-Western/Thomson Learning. All rights r...
A Consumption Function <ul><li>For simplicity, we assume that points of aggregate consumption, when plotted against aggreg...
A  Consumption Function Derived from the Equation  C  = 100 + .75 Y <ul><li>At a national income of zero, consumption is $...
A Consumption Function Derived from the Equation  C  = 100 + .75 Y 850 1,000 700 800 550 600 400 400 250 200 175 100 160 8...
Consumption and Saving <ul><li>Since there are only two places income can go:  consumption or saving, the fraction of addi...
Marginal Propensity to Consume: Again MPC =  Change in Consumption _____________________________________________ Change in...
An Aggregate Consumption Function Derived from the Equation  C  = 100 + .75 Y 850 1,000 700 800 550 600 400 400 250 200 17...
Marginal Propensity to Consume MPC =  Change in Consumption _____________________________________________ Change in DI tha...
Marginal Propensity to Consume <ul><li>To estimate the initial effect of a tax cut on consumer spending,economists must fi...
.80 .85 .90 .95 1.0 Canada United States Netherlands United Kingdom Germany Italy Japan France GLOBAL  PERSPECTIVE Average...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
Shifts in the consumption function <ul><li>The consumption function does not always stand still </li></ul><ul><li>  dispo...
FIGURE  24-6   Shifts of the Consumption Function Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Re...
Factors That Shift the Consumption Function <ul><li>Consumption function shifted by changes in: </li></ul><ul><ul><li>Weal...
Shifts in the consumption function:  Wealth <ul><li>Not just income, but total amount of income  accumulated </li></ul><ul...
Shifts in the consumption function:  Price Level <ul><li>Higher prices lower consumption </li></ul><ul><li>Lower prices ra...
Shifts in the consumption function: The real interest rate <ul><li>High interest rate => lower consumption </li></ul><ul><...
Shifts in the consumption function: future expectations <ul><li>If people think they will make more money in the future, t...
A Return to our Initial Question <ul><li>Why didn’t the tax rebates of 1975 and 2001 result in the intended increase of co...
TABLE  24-2   Incomes of Three Consumers Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Why The Tax Rebate Failed in 1975 and 2001 <ul><li>The tax cuts failed to stimulate consumption very much because they wer...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
Investment <ul><li>Investment is the most volatile of all AD components </li></ul><ul><li>Does not follow movements in dis...
Investment <ul><li>Because investment is volatile, it can have a major impact on AD, which affects output and employment i...
Investment <ul><li>Volatility of investment is largely attributed to  expectations of the future , which directly affect t...
Determinants of Investment <ul><li>The level of investment is determined by: </li></ul><ul><li>Revenues </li></ul><ul><li>...
Revenue as a determinant of investment <ul><li>Investment depends upon the revenues that will be generated by the state of...
Costs as a determinant of investment <ul><li>Capital is a durable good (lasts a long time) </li></ul><ul><li>Costs include...
Expectations as a determinant of investment <ul><li>Investment is a gamble on the future </li></ul><ul><li>Businesses spen...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
Net Exports <ul><li>Net Exports are the third leg of AD to be discussed </li></ul><ul><li>NX are also extremely variable <...
Year 2000 – US Trade with China By 1-digit SITC commodity In millions of dollars  Source: US Census Bureau 1-digit SITC Co...
National Income and Imports <ul><li>Imports are positively related to income and output </li></ul><ul><li>When GDP rises, ...
National Income and Exports <ul><li>Exports depend on foreign nations levels of output and income </li></ul><ul><li>As for...
National Income and Net Exports <ul><li>When our economy grows faster than economies we trade with, net exports shrink </l...
Relative Prices and Net Exports <ul><li>Relative prices are also important in determining net exports </li></ul><ul><li>Wh...
Relative Prices and Net Exports <ul><li>A rise in the relative prices of a country’s goods will reduce net exports </li></...
Relative Prices and Net Exports <ul><li>A rise in the relative prices of a  foreign  country’s goods will increase net exp...
Relative Prices and Exchange Rates <ul><li>Consider a CharLeenese car that costs 3 million CharLeenese  Chars </li></ul><u...
Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Pro...
How Predictable is Aggregate Demand? <ul><li>AD is not the easiest thing in the world to predict </li></ul><ul><li>We can ...
How Predictable is Aggregate Demand? <ul><li>Investment is more volatile than consumption, and thus even more difficult to...
How Predictable is Aggregate Demand? <ul><li>Net exports are affected both by developments at home, as well as development...
To Sum Up <ul><li>Aggregate Demand can be viewed as a schedule of different levels of output demanded at different prices ...
To Sum Up <ul><li>Examining the circular flow of expenditures and income diagram, we can see that national income and dome...
To Sum Up <ul><li>There is clearly a relationship between consumption and disposable income </li></ul><ul><li>The relation...
To Sum Up <ul><li>Marginal Propensity to Consume shows how much consumption will go up due to an increase in DI </li></ul>...
To Sum Up <ul><li>Because both the 1975 and 2001 tax rebates were advertised as “one time only” rebates, people did not se...
To Sum Up <ul><li>Investment is comprised mainly of inventory change, purchase of new housing, and purchase of capital by ...
To Sum Up <ul><li>Net exports are determined by national incomes and relative prices </li></ul><ul><li>NX are determined b...
To Sum Up <ul><li>AD is not an easy thing to predict </li></ul><ul><li>Consumption can be affected by unexpected changes i...
NOW GO AWAY! <ul><li>Next lecture Chapter 8 </li></ul>
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Char Lee Econ Lecture 22

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Transcript of "Char Lee Econ Lecture 22"

  1. 1. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  2. 2. Demand Management <ul><li>In our first lecture we introduced Aggregate Demand </li></ul><ul><li>We discussed different ways the government can shift the AD curve </li></ul><ul><li>1. Increase/decrease government spending </li></ul><ul><li>2. Influence private spending through </li></ul><ul><li>-Tax cuts </li></ul><ul><li>-Other policy tools </li></ul>
  3. 3. Demand Management <ul><li>In 2000 George W. Bush wanted to increase consumer spending, so they issued a tax rebate </li></ul><ul><li>But consumers actually wound up saving the large portion of the rebate, rather than using it to buy things. </li></ul><ul><li>This is similar to what happened when congress issued a tax rebate in 1975 </li></ul><ul><li>Why did this tax cut fail to achieve the desired goal? </li></ul>
  4. 4. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  5. 5. AD, Domestic Product, and National Income <ul><li>Aggregate Demand </li></ul><ul><ul><li>the total amount that all consumers, business firms, and government agencies are willing to spend on final goods and services </li></ul></ul><ul><ul><li>AD is a schedule, not a fixed number: </li></ul></ul><ul><ul><ul><li>It shows the different quantities of total output demanded at different price levels </li></ul></ul></ul>AD = C Consumer Expenditure + I Investment + G Government Purchases + NX Net Exports
  6. 6. AD, Domestic Product, and National Income <ul><li>Consumer Expenditure </li></ul><ul><ul><li>the total amount spent by consumers on newly produced goods and services (excluding purchases of new homes, which are considered investment goods) </li></ul></ul><ul><li>Investment Spending </li></ul><ul><ul><li>the sum of the expenditures of business firms on new plant and equipment and households on new homes. Financial “investments” are not included, nor are resales of existing physical assets. </li></ul></ul>
  7. 7. AD, Domestic Product, and National Income <ul><li>Government Purchases </li></ul><ul><ul><li>the goods and services purchased by all levels of government. </li></ul></ul><ul><li>Net Exports </li></ul><ul><ul><li>the difference between U.S. exports and U.S. imports. </li></ul></ul><ul><ul><li>Indicates the difference between what we sell to foreigners and what we buy from them </li></ul></ul>
  8. 8. BUT WAIT!!! <ul><li>This is the exact same formula we used to calculate GDP last week! </li></ul><ul><li>How can these two be the same? </li></ul><ul><li>1. Logically: All of the things people are willing to buy must equal all of the things that people make and sell </li></ul><ul><li>Pictorially </li></ul>
  9. 9. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  10. 10. FIGURE 24-1 The Circular Flow of Expenditures and Income 1 3 6 5 4 2 Investors Government Consumers Financial System Saving ( S ) Consumption (C) Investment (I) C + I Government C + I + G Imports ( IM ) Exports ( X ) C + I + G + Transfers Disposable Income ( DI ) Taxes ( X – IM ) Purchases ( G ) Firms (produce the domestic product) Rest of the World Gross National Income ( Y )
  11. 11. Circular Flow of Spending, Production, and Income <ul><li>Circular flow diagram: shows the relationship of the different components of expenditure and income </li></ul><ul><li>National income=domestic product </li></ul><ul><li>Wages plus rents plus interest plus profits equals output </li></ul>
  12. 12. AD, Domestic Product, and National Income <ul><li>National Income </li></ul><ul><li>-the sum of the incomes that all individuals in the economy earned in the forms of wages, interest, rents, and profits. </li></ul><ul><li>-Excludes government transfer payments </li></ul><ul><li>-Pre-tax </li></ul><ul><li>Not all national income goes directly to consumers! </li></ul>
  13. 13. FIGURE 24-1 The Circular Flow of Expenditures and Income 1 3 6 5 4 2 Investors Government Consumers Financial System Saving ( S ) Consumption (C) Investment (I) C + I Government C + I + G Imports ( IM ) Exports ( X ) C + I + G + Transfers Disposable Income ( DI ) Taxes ( X – IM ) Purchases ( G ) Firms (produce the domestic product) Rest of the World Gross National Income ( Y )
  14. 14. National Income vs. Disposable Income <ul><li>Not all national income goes directly to consumers </li></ul><ul><li>Some money is deducted in the form of taxes </li></ul><ul><li>Some money is added in the form of transfer payments </li></ul>DI = GDP - Taxes + Transfer Payments = GDP – (Taxes – Transfers) = Y - T
  15. 15. AD, Domestic Product, and National Income <ul><li>Disposable Income </li></ul><ul><ul><li>the sum of the incomes of all the individuals in the economy after all taxes have been deducted and all transfer payments have been added </li></ul></ul><ul><li>DI = GDP - Taxes + Transfers = Y - T </li></ul>
  16. 16. Some Questions To Think About: <ul><li>Does flow of spending and income grow larger or smaller as we move around the circle? </li></ul><ul><li>Is the output that firms produce at point 5 (the GDP) equal to aggregate demand? What makes these two quantities equal if so? If not, what will happen? </li></ul>
  17. 17. Some Questions To Think About <ul><li>Do the government’s accounts balance so that net of transfers equals government spending? If not, what happens? </li></ul><ul><li>Is our international trade balanced so that exports equal imports? What happens if we experience a trade surplus or trade deficit? </li></ul>
  18. 18. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  19. 19. Consumption <ul><li>Consumption is the single largest component of GDP, about 66% over the last decade </li></ul><ul><li>Major components of consumption: </li></ul><ul><li>Cars </li></ul><ul><li>Food </li></ul><ul><li>Medical Care </li></ul>
  20. 20. 100 5,151 Total Consumption 865 Other 816 Medical Care 205 Transportation 310 Household operation 779 Housing 58 2,974 Services 375 Other 133 Energy 264 Clothing & Apparel 772 Food 30 1,545 Nondurable Goods 125 Other 254 Household Equipment 253 Motor Vehicles 12 632 Durable Goods Percent of total Value of category (1996, $, billion) Category of Consumption
  21. 21. Evolution of Consumption in the 20 th Century <ul><li>1918-US households spent 41% of income on food and drink </li></ul><ul><li>1999-19% </li></ul><ul><li>Spending on apparel has fallen from 18% of income to 6% </li></ul><ul><li>1918-Americans spent 1% of income on automobiles </li></ul><ul><li>Now-23% of spending on vehicle related transportation </li></ul>
  22. 22. Evolution of Consumption in the 20 th Century <ul><li>Housing has risen from 14% to 20% of national income during this period </li></ul><ul><li>Televisions, cell phones, and VCRs have increased entertainment expenses </li></ul><ul><li>Biggest increase in consumption spending has been for health care </li></ul>
  23. 23. Consumption, Income, and Saving <ul><li>Consumption, Income, and Saving are all linked </li></ul><ul><li>Personal saving is the part of disposable income that is not consumed </li></ul>4.9% Memo: Saving as percent of personal DI 272 Equals: Personal Saving 5,314 Less: Personal outlays (consumption +interest) 5,586 Equals: Personal Disposable Income 864 Less: Personal tax and nontax payments 6,450 Personal Income Amount, 1996 ($, billion) Item
  24. 24. Consumption, Saving, and Income 28,360 +1,640 30,000 27,830 +1,170 29,000 27,240 +760 28,000 26,600 +400 27,000 25,850 +150 26,000 25,000 0 25,000 24,110 -110 24,000 (3) Consumption ($) (2) Net saving (+) or dissaving (-) ($) (1) Disposable Income ($)
  25. 25. FIGURE 24-2 Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Real consumer spending Real disposable income Billions of 1996 Dollars 2000 1990 1980 1970 1960 1950 1940 1930 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,500 4,000 $6,500 6,000 5,500 5,000 World War II The Great Depression
  26. 27. Consumption, Saving, and Income <ul><li>Clearly consumption and DI are related </li></ul><ul><li>When DI rises, consumption rises </li></ul><ul><li>When DI falls, consumption falls </li></ul><ul><li>However we are still unclear on how much DI influences consumption </li></ul>
  27. 28. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  28. 29. Consumption, Saving, and Income <ul><li>To understand the way consumption affects national output, we need some new tools. </li></ul><ul><li>We need to look at how many extra dollars of consumption are induced by each extra dollar of disposable income </li></ul><ul><li>This relationship is shown by the consumption function </li></ul>
  29. 30. Consumer Spending and Income <ul><li>A scatter diagram with U.S. data shows the close relationship between real disposable income and real consumer spending. </li></ul>
  30. 31. FIGURE 24-3 Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserved. $3,244 $5,677 $5,237 $2,869 Real Consumer Spending 0 Real Disposable Income 2001 2000 1999 1998 1997 1995 1976 1996 1994 1992 1990 1991 1989 1988 1987 1986 1985 1980 1984 1979 1978 1974 1970 1964 1960 1955 1945 1943 1942 1947 1941 1939 1929
  31. 32. Consumer Spending and Income <ul><li>Assume in 1963 you want to calculate how much an increase in disposable income will increase consumption </li></ul><ul><li>You could look at a scatter diagram of consumption vs. DI of the years leading up until that year </li></ul>
  32. 33. FIGURE 24-4 Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 1900 1700 1500 1360 1300 1180 1100 900 1900 1700 1500 1300 1100 900 Real Disposable Income Real Consumer Spending 0 B A $200 billion $180 billion 1947 1963
  33. 34. Consumer Spending and Income <ul><li>When the data are converted into a consumption function diagram--with income on one axis and consumption on the other--the relationship between real consumer spending and real disposable income is almost linear, with a slope of about 0.9. </li></ul>
  34. 35. Consumer Spending and Income <ul><li>If there were a tax cut of $10 billion, effectively increasing DI by that amount, according to the graph how much would you expect consumption to increase by? </li></ul><ul><li>How much would you expect savings to increase by? </li></ul>
  35. 36. The Consumption Function and the MPC <ul><li>Consumption function </li></ul><ul><ul><li>illustrates the relationship between total consumer expenditures and total disposable income in the economy, holding constant all other determinants of consumer spending. </li></ul></ul><ul><ul><ul><li>MPC =  consumption   disposable income </li></ul></ul></ul><ul><ul><li>Can be used to estimate the initial effect on consumer spending of a tax cut </li></ul></ul>
  36. 37. FIGURE 24-5 A Consumption Function Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 5,200 4,800 4,400 4,000 3,600 3,200 0 2,700 3,000 3,300 3,600 3,900 $4,200 C $400 $300 Real Disposable Income, DI
  37. 38. TABLE 24-1 Consumption and Income in Hypothetical Economy Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
  38. 39. A Consumption Function <ul><li>For simplicity, we assume that points of aggregate consumption, when plotted against aggregate income, lie along a straight line. </li></ul><ul><li>The slope of the consumption function ( b ) is called the marginal propensity to consume (MPC), or the fraction of a change in income that is consumed, or spent. </li></ul>
  39. 40. A Consumption Function Derived from the Equation C = 100 + .75 Y <ul><li>At a national income of zero, consumption is $100 billion ( a ). </li></ul><ul><li>For every $100 billion increase in income (  Y ), consumption rises by $75 billion (  C ). </li></ul>
  40. 41. A Consumption Function Derived from the Equation C = 100 + .75 Y 850 1,000 700 800 550 600 400 400 250 200 175 100 160 80 100 0 AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) AGGREGATE INCOME, Y (BILLIONS OF DOLLARS)
  41. 42. Consumption and Saving <ul><li>Since there are only two places income can go: consumption or saving, the fraction of additional income that is not consumed is the fraction saved. The fraction of a change in income that is saved is called the marginal propensity to save (MPS). </li></ul><ul><li>Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore, </li></ul>
  42. 43. Marginal Propensity to Consume: Again MPC = Change in Consumption _____________________________________________ Change in DI that produces the change in Consumption
  43. 44. An Aggregate Consumption Function Derived from the Equation C = 100 + .75 Y 850 1,000 700 800 550 600 400 400 250 200 175 100 160 80 100 0 AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) AGGREGATE INCOME, Y (BILLIONS OF DOLLARS)
  44. 45. Marginal Propensity to Consume MPC = Change in Consumption _____________________________________________ Change in DI that produces the change in Consumption MPC = $75 _____ $100 = 0.75
  45. 46. Marginal Propensity to Consume <ul><li>To estimate the initial effect of a tax cut on consumer spending,economists must first estimate the MPC and then multiply the amount of the tax cut by the estimated MPC </li></ul><ul><li>Because they never know the true MPC with certainty, their prediction is always subject to some margin of error </li></ul><ul><li>(Baumol, 2004) </li></ul>
  46. 47. .80 .85 .90 .95 1.0 Canada United States Netherlands United Kingdom Germany Italy Japan France GLOBAL PERSPECTIVE Average Propensities to Consume, Selected Nations, 1999 Statistical Abstract of the United States, 2000 .986 .976 .972 .940 .907 .873 .869 .842
  47. 48. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  48. 49. Shifts in the consumption function <ul><li>The consumption function does not always stand still </li></ul><ul><li> disposable income  movement along a consumption function </li></ul><ul><li> any other variable that affects consumption  shift in the entire consumption function </li></ul>
  49. 50. FIGURE 24-6 Shifts of the Consumption Function Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Real Consumer Spending Real Disposable Income Shifts of consumption function Movements along consumption function C 2 C 1 C 0 A
  50. 51. Factors That Shift the Consumption Function <ul><li>Consumption function shifted by changes in: </li></ul><ul><ul><li>Wealth </li></ul></ul><ul><ul><li>Price level </li></ul></ul><ul><ul><li>Real interest rate </li></ul></ul><ul><ul><li>Expectations of future income </li></ul></ul>
  51. 52. Shifts in the consumption function: Wealth <ul><li>Not just income, but total amount of income accumulated </li></ul><ul><li>The more money I have, the more I will be willing to spend </li></ul><ul><li>E.G. stock market booms and busts </li></ul>
  52. 53. Shifts in the consumption function: Price Level <ul><li>Higher prices lower consumption </li></ul><ul><li>Lower prices raise consumption </li></ul><ul><li>Higher price levels = lower level of real wealth </li></ul><ul><li>Lower price levels = higher level of real wealth </li></ul>
  53. 54. Shifts in the consumption function: The real interest rate <ul><li>High interest rate => lower consumption </li></ul><ul><li>Low interest rate => raise consumption </li></ul><ul><li>Makes sense theoretically, BUT </li></ul><ul><li>Studies have shown that interest rates have little to no influence on consumption </li></ul>
  54. 55. Shifts in the consumption function: future expectations <ul><li>If people think they will make more money in the future, they will be more willing to consume today </li></ul><ul><li>If people are not optimistic about the future, they will be more likely to save today </li></ul>
  55. 56. A Return to our Initial Question <ul><li>Why didn’t the tax rebates of 1975 and 2001 result in the intended increase of consumption? </li></ul><ul><li>Largely due to this concept of expectations of the future </li></ul><ul><li>Examine three consumers, named “No Change,” “Temporary Rise,” and “Permanent Rise.” </li></ul>
  56. 57. TABLE 24-2 Incomes of Three Consumers Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
  57. 58. Why The Tax Rebate Failed in 1975 and 2001 <ul><li>The tax cuts failed to stimulate consumption very much because they were perceived as only temporary. </li></ul><ul><li>People probably figured out that it would not make much difference to their long-term well-being, and therefore did not change their spending habits much. </li></ul>?
  58. 59. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  59. 60. Investment <ul><li>Investment is the most volatile of all AD components </li></ul><ul><li>Does not follow movements in disposable income like consumption </li></ul><ul><li>A 3.2 percent drop in growth rate from 2000-2001 was accompanied by a 14.1 percent drop in the growth rate of investment </li></ul>
  60. 61. Investment <ul><li>Because investment is volatile, it can have a major impact on AD, which affects output and employment in the short run </li></ul><ul><li>Investment also leads to capital accumulation, which also increases potential output and growth in the long run </li></ul>
  61. 62. Investment <ul><li>Volatility of investment is largely attributed to expectations of the future , which directly affect the state of business confidence </li></ul><ul><li>Difficult to measure, much less control </li></ul><ul><li>Thus, economists concentrate on controlling other determinants of investment </li></ul>
  62. 63. Determinants of Investment <ul><li>The level of investment is determined by: </li></ul><ul><li>Revenues </li></ul><ul><li>Costs </li></ul><ul><li>Expectations </li></ul>
  63. 64. Revenue as a determinant of investment <ul><li>Investment depends upon the revenues that will be generated by the state of overall economic activity </li></ul><ul><li>Investment is thus very cyclical: </li></ul><ul><li>Business downturn 1979-82, output fell sharply and investment fell by 22 percent </li></ul>
  64. 65. Costs as a determinant of investment <ul><li>Capital is a durable good (lasts a long time) </li></ul><ul><li>Costs included in costs of capital: </li></ul><ul><li>1. Price </li></ul><ul><li>2. Interest Rate </li></ul><ul><li>3. Taxes </li></ul>
  65. 66. Expectations as a determinant of investment <ul><li>Investment is a gamble on the future </li></ul><ul><li>Businesses spend much energy analyzing investments and trying to narrow the uncertainties about their investments </li></ul><ul><li>If future expectations are positive, businesses will invest more now </li></ul>
  66. 67. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  67. 68. Net Exports <ul><li>Net Exports are the third leg of AD to be discussed </li></ul><ul><li>NX are also extremely variable </li></ul><ul><li>Net Exports are determined by: </li></ul><ul><li>National Incomes </li></ul><ul><li>2. Relative prices and exchange rates </li></ul>
  68. 69. Year 2000 – US Trade with China By 1-digit SITC commodity In millions of dollars Source: US Census Bureau 1-digit SITC Commodity Exports Imports (0) Food and Live Animals 472.95 1,021.17 (1) Beverages and Tobacco 4.93 32.53 (2) Crude Materials, Inedible, Except Fuels 2,566.50 614.03 (3) Mineral Fuels, Lubricants and Related Materials 59.77 729.76 (4) Animal and Vegetable Oils, Fats and Waxes 20.90 7.48 (5) Chemicals and Related Products, N.E.S. 2,325.37 1,809.46 (6) Manufactured Goods Classified Chiefly by Material 1,271.89 10,286.90 (7) Machinery and Transport Equipment 8,067.82 34,946.75 (8) Miscellaneous Manufactured Articles 1,240.14 49,475.39 (9) Commodities and Transactions, N.E.S. 222.76 1,139.49 Total 16,253.03 100,062.96
  69. 70. National Income and Imports <ul><li>Imports are positively related to income and output </li></ul><ul><li>When GDP rises, US imports increase because some of the C + G + I come from foreign producers, and America uses foreign made inputs (like oil or steel) </li></ul><ul><li>When GDP falls, imports fall </li></ul>
  70. 71. National Income and Exports <ul><li>Exports depend on foreign nations levels of output and income </li></ul><ul><li>As foreign output rises, their demand for national products increases, as some of their C + I + G comes from our own nation </li></ul><ul><li>Thus, as foreign output and income rises, national exports increase </li></ul><ul><li>As foreign output and income falls, exports fall </li></ul>
  71. 72. National Income and Net Exports <ul><li>When our economy grows faster than economies we trade with, net exports shrink </li></ul><ul><li>When economies we trade with grow faster than our economy, net exports grow </li></ul><ul><li>US Economy stagnated 1990-1992 => </li></ul><ul><li>net exports rose from -$55 billion to -$16 billion, </li></ul><ul><li>US Economy grew faster than other economies </li></ul><ul><li>net exports fell from -$16 billion to -$380 billion </li></ul>
  72. 73. Relative Prices and Net Exports <ul><li>Relative prices are also important in determining net exports </li></ul><ul><li>When comparing relative prices, we are looking at a rise or decline in the price of goods in two different countries </li></ul><ul><li>If the prices rise in our country and fall in another country, our goods are now more expensive relative to the other country </li></ul>
  73. 74. Relative Prices and Net Exports <ul><li>A rise in the relative prices of a country’s goods will reduce net exports </li></ul><ul><li>Foreign countries will be less willing to buy our products, and we will be more willing to buy theirs </li></ul><ul><li>A drop in the relative prices of a country’s goods will increase net exports </li></ul><ul><li>We will be less willing to buy foreign country’s products, and they will be more willing to buy ours </li></ul>
  74. 75. Relative Prices and Net Exports <ul><li>A rise in the relative prices of a foreign country’s goods will increase net exports </li></ul><ul><li>We will be less willing to buy their products, and they will be more willing to buy ours </li></ul><ul><li>A drop in the relative prices in a foreign country’s goods will decrease net exports </li></ul><ul><li>We will be more willing to buy their products, and they will be less willing to buy ours </li></ul>
  75. 76. Relative Prices and Exchange Rates <ul><li>Consider a CharLeenese car that costs 3 million CharLeenese Chars </li></ul><ul><li>If 1 dollar = 100 Chars , then: </li></ul><ul><li>1 car = $30,000 </li></ul><ul><li>But if the exchange rate changes </li></ul><ul><li>1 dollar = 150 Chars , then: </li></ul><ul><li>1 car = $20,000 </li></ul>
  76. 77. Today <ul><li>Aggregate Demand, Domestic Product, and National Income </li></ul><ul><li>The Circular Flow of Spending, Production and Income </li></ul><ul><li>Consumer Spending and Income: The important Relationship </li></ul><ul><li>The consumption function and the Marginal Propensity to Consume </li></ul><ul><li>Factors that Shift the Consumption Function </li></ul><ul><li>The Extreme Variability of Investment </li></ul><ul><li>The Determinants of Net Exports </li></ul><ul><li>How predictable is AD? </li></ul>
  77. 78. How Predictable is Aggregate Demand? <ul><li>AD is not the easiest thing in the world to predict </li></ul><ul><li>We can use consumer spending to help predict AD, but unexpected movements of the stock market or poor predictions of the future can affect the accurateness of this prediction </li></ul><ul><li>As the 1975 and 2001 tax rebates showed, it’s also difficult to influence consumption through temporary tax cuts or rebates </li></ul>
  78. 79. How Predictable is Aggregate Demand? <ul><li>Investment is more volatile than consumption, and thus even more difficult to predict </li></ul><ul><li>This is partly because investment is so strongly related to expectations of the future and confidence, which is next to impossible to calculate, much less control </li></ul>
  79. 80. How Predictable is Aggregate Demand? <ul><li>Net exports are affected both by developments at home, as well as developments abroad. </li></ul><ul><li>Thus, it’s not easy to predict net exports, as so much of their determination is out of our hands </li></ul><ul><li>Even government spending is not as predictable as you would think </li></ul>
  80. 81. To Sum Up <ul><li>Aggregate Demand can be viewed as a schedule of different levels of output demanded at different prices levels </li></ul><ul><li>AD is comprised of consumption, investment, government spending, and net exports </li></ul>
  81. 82. To Sum Up <ul><li>Examining the circular flow of expenditures and income diagram, we can see that national income and domestic product must, for the most part, be equal </li></ul><ul><li>Disposable income equals national income minus taxes plus transfers </li></ul>
  82. 83. To Sum Up <ul><li>There is clearly a relationship between consumption and disposable income </li></ul><ul><li>The relationship can be graphically depicted in a scatter diagram, comparing DI to C </li></ul><ul><li>When we measure the general slope these points make, have calculated the marginal propensity to consume </li></ul>
  83. 84. To Sum Up <ul><li>Marginal Propensity to Consume shows how much consumption will go up due to an increase in DI </li></ul><ul><li>The consumption function itself can be shifted up or down due to changes in wealth, price levels, and future income expectations </li></ul>
  84. 85. To Sum Up <ul><li>Because both the 1975 and 2001 tax rebates were advertised as “one time only” rebates, people did not see any long term benefit from them. </li></ul><ul><li>As a result, they did not feel their future incomes were affected, so consumption did not rise as much as expected </li></ul>
  85. 86. To Sum Up <ul><li>Investment is comprised mainly of inventory change, purchase of new housing, and purchase of capital by firms </li></ul><ul><li>Investment is extremely volatile </li></ul><ul><li>Investment is influenced by revenues, costs, and expectations </li></ul><ul><li>We generally focus on interest (one of the costs of investment) </li></ul>
  86. 87. To Sum Up <ul><li>Net exports are determined by national incomes and relative prices </li></ul><ul><li>NX are determined by both our national incomes, as well as foreign national incomes </li></ul><ul><li>We have little control over foreign prices as well </li></ul><ul><li>As a result, NX is not very controllable </li></ul>
  87. 88. To Sum Up <ul><li>AD is not an easy thing to predict </li></ul><ul><li>Consumption can be affected by unexpected changes in wealth in the future, or plain poor prediction of future market conditions </li></ul><ul><li>Investment is highly volatile </li></ul><ul><li>Net exports are partially determined by other countries </li></ul><ul><li>Government spending is not as predictable as one would have guessed </li></ul>
  88. 89. NOW GO AWAY! <ul><li>Next lecture Chapter 8 </li></ul>
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